KW: Thought for the day
Though it seems like only yesterday, it’s been over a decade now since my former employer, Lehman Brothers went bankrupt, and in the process, helped instigate a massive global financial crisis.
That collapse catapulted the Federal Reserve on a mission to, in its own narrative, save the economy from further collapse. In fact, its creation of $4.5 trillion to purchase U.S. treasury and mortgage related bonds from the big private banks in exchange for continued liquidity was the biggest subsidy in U.S. history.
In some ways, we seem much better off now. The stock market is back to record highs and employment is still near record highs.
But that only tells half the story. That’s because the last financial crisis was about debt and debt levels have increased substantially since 2008. The entire “recovery” was built on debt.
Today we’re standing on a dangerous financial precipice. The shadows of 2008 are growing larger. And we’re in unknown territory.
The risks posed by the largest of the private banks still exist, only now they’re even bigger than they were in 2007–08 and taking place against a backdrop of even more debt. That’s because there’s a lot more money artificially supporting the financial system than we had going into the last crisis.
To visualize this, imagine pulling the tablecloth out from under a table full of dishes. The higher the dishes are stacked, the greater the crash when they fall.
And the central banks have much less “dry powder” to work with this time around than they had during the last crisis.
Perhaps most alarming, we have seen virtually no real steps to reform the financial system.
Despite some cosmetic regulations to curtail certain risky behaviors since the repeal of the Glass-Steagall Act in 1999, there is still no division between depositors’ funds and those used by banks for speculation.
And the big banks continue to make massive trading bets that threaten the financial system if they go bad.
It has been part of a coordinated effort to plaster over potential financial instability in the largest countries and in private banks.
It has, in turn, created asset bubbles that could explode into an even greater crisis the next time around.
Global debt-to-GDP ratios have increased. Companies and governments have piled on more debt than before. Emerging-market debt, led by China, is also at a record.
Eliminating all that debt is the ultimate solution for avoiding another crisis. But now that the central banks are cutting rates again and making more cheap credit, or “dark money” available, the problem’s only getting bigger.
Now the Fed’s been pumping in hundreds of billions of dollars to prop up the “repo” market. But the bulk of this money hasn’t gone to commercial banks that might use it to loan to businesses or to purchase housing. Instead, most of the money’s gone to brokerage firms and investment banks that use it to gamble in the markets.
Is it a coincidence that the stock market’s back to record heights again? Of course, Fed chairman Jerome Powell appeared before Congress, where he said these were just routine “open market operations” and basically, that there’s nothing to see here.
But the last time the Fed conducted these “open market operations” was during the financial crisis. Hardly routine. But that’s the big lie the Fed’s pushing.
The Fed’s latest interventions are also raising renewed concerns about moral hazard, where market participants take on greater risk in the expectation that the Fed will bail them out if things go bad. And that’s dangerous.
When the next shoe drops from our inflated bubble markets, it will be the debt markets that lead the way.
Corporate debt is the biggest potential flash point. Spurred on by the Fed’s artificially low interest rates, corporations have been on a borrowing spree, using the money to splurge on stock buybacks that increase their share prices while doing little to increase productivity.
The IMF has stressed its concern about high levels of risky corporate debt before. But now the IMF admits that global central bank policies to lower interest rates in order to stave off immediate economic risks have made the situation worse.
Their actions have led to “worrisome” levels of poor credit-quality debt as well as increased financial instability.
It noted that 40% of all corporate debt in major economies could be “at risk” in the event of another global economic downturn, with debt levels greater than those of the 2008–09 financial crisis.
Much of that has been related to dark money making debt cheaper to acquire.
For nearly a decade, the world’s central banks have been printing tens of trillions of dollars of “money.” The “Big Three” central banks — the Fed, the European Central Bank and the Bank of Japan — have collectively held rates at a 0% average since the global financial crisis began.
The amount of securities they held on their books alone in 2017 was nearly $14 trillion, equivalent to a staggering 17% of global GDP.
The result has been to inflate a massive debt bubble. The world’s debt pile sits near a record $244 trillion as of the beginning of this year.
That’s three times the size of global GDP. It means that for every dollar of growth, the world is borrowing three dollars. Plus, right now, U.S. corporate debt stands at $10 trillion. That’s the equivalent of 48% of U.S. GDP.
The growing corporate debt problem has even prompted the Federal Reserve to identify it as a potential risk to the financial system.
The share of new, large loans that have been going to comparatively risky borrowers exceeds peak levels reached previously in 2007 and 2014.
Maybe the most dangerous trend is the growth of collateralized loan obligations (CLOs).
These are much like the “collateralized debt obligations” (CDOs), which helped bring the financial system to the point of collapse in 2008. But instead of repackaging mortgages, CLOs repackage corporate loans, as well as consumer credit like auto loans.
But they could be even more dangerous than CDOs, as former banker Satyajit Das reports:
If firms begin having problems with debt repayment, a huge wave of defaults could result, followed by crisis as defaults spread like a contagion.
No two crises are exactly the same, so whatever form it takes, it won’t be identical to 2008. But you can bet the Fed will respond with more rate cuts and quantitative easing.
But here’s the problem: the main difference between 2008 and now is that central bank sheets are dramatically higher today.
The central banks just don’t have the room to accommodate nearly as much easing this time around, as opposed to 2008. They’ve spent too much of their “dry powder” trying to repair the last crisis, and there’s a limit to how much they can expand their balance sheets (although in fairness, no one can really say what limit is).
One of my former employers, J.P. Morgan Chase, says the next crisis may become so serious “that the next financial crash may be so cataclysmic that the Federal Reserve may have to enter the market to buy up stocks…”
Think about what that means. JPM has spent tens of billions of dollars over the past several years buying back its own stock to boost the price. Now they want the Fed to directly bail out the stock market next time around — and JP Morgan stock by implication.
Call it whatever you want, just don’t call it the free market. You can call it welfare for Wall Street instead.
It’s not sustainable. But that doesn’t mean the central banks won’t try to keep it going with lots of cheap credit, or what I call “dark money.”
“Dark money” comes from central banks. It goes to the biggest private banks and financial institutions first. On Wall Street, knowledge of and access to dark money means trillions of dollars per year flowing in and around global stock, bond and derivatives markets.
As I’ve said many times, dark money is the #1 secret life force of today’s rigged financial markets. It drives whole markets up and down. It’s the reason for today’s financial bubbles.
It should keep the ball rolling for a while, until one day it doesn’t.